Via Societe Generale's Andrew Lapthorne,
Style performance dictated by weak fundamentals
Investment style performance during 2014 was far more consistent with that of global bond yields (which dropped to historically low levels) than an acceleration in economic growth. The two charts below make this point. The relative performance of our aggregate quality investment style typically performs inversely to global equities but has a high positive correlation to bond prices. Given our quality measures are often by construction low beta, this inverse relationship with global equities is not unusal.
What is striking is how sovereign bond markets and investment style performance have been in lock-step for the last couple of years. In particular both started reacting to a slowdown in economic growth early in 2014, whilst headline indices only really started to come unstuck in the second half of 2014. Investors were willing to take equity risk, thanks largely to the unerring support of central bankers, but they seemed not so keen to take economic risk. These risks then became all too apparent in the second half on 2014 with the collapse of commodity prices, most notably oil along with economic growth and inflation expectations.
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One argument we have made in the past is that the particularly strong performance of equity quality and US Treasuries last year was a function of these assets bouncing back after quite a savage drop post the intital May 2013 Fed-tapering induced sell-off. Back then bond yields rose and defensive assets sold off in the expectation of an end to QE and better global economic growth prospects. While the former has now occurred (though replaced by other countries’ QE), the latter is proving harder to come by. In fact the dominant theme we see across asset, sector and style performance is a market responding to disappointing economic growth momentum. As we show below, the performance of quality equities is entirely consistent with the direction of global earnings momentum (note that quality performance is inverted in the chart).
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So it turns out Fed tapering was largely a distraction. The driver has been weaker than expected global growth, and if the performance of global sovereign bonds and quality equities is to be believed then overall equity volatility is likely to be much higher in 2015 than it was in 2014, in the absence of any improvement of economic conditions.
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Quality stocks along with everything else are expensive
The upshot of all this strong performance is that quality stocks are trading at very elevated levels, having only exceeded these levels during the Tech boom in 1998/99. This is undoubtedly a concern going forward especially as the higher beta alternatives (whether value or growth stocks) are not exactly offering enticing valuations either. As we also show below value stocks, while by definition the cheapest part of the market, are also trading at high PE multiples to where they typically trade. None of this is very encouraging.
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These expensive “style” valuations have to be put in the context of equities overall being really expensive. For example, the median EV/EBITBDA on both Europe and US stocks have rarely been this elevated, a worry for many, but for others this expense is simply explained away by equally expensive valuations on fixed income asssets or indeed cash.
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The reality though is that higher valuations have historically led to disappointing future returns and a greater danger of loss. We quantified this by sorting all stocks into four valuation buckets based on their starting EV/EBITDA valuation and measured their performance over the next three years. We did this monthly since 1989 using all stocks that existed in the FT World index during this time, and as we show below, the expected price return from US stocks was just 1.6% and in Europe you actually made a loss.
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Conclusion
So what to do? Increasing risk while valuations in the equity market are so elevated seems dangerous, so the obvious answer is to hide in cash. But for many this is a difficult to do. Our quality income strategy has been reducing the number of stocks it holds, concentrating on those which still meet our quality and valuation criteria. This keeps the dividend yield high and the balance sheet risk low, but also comes at the cost of increasing idiosyncratic risks. For those willing to take on greater volatility, our value styles and our Global Value index continues to highlight Japan, with all its macro volatility, as a region of interest. But as we highlighted last month, given valuation dispersion is so tight, avoiding risk will be pivotal in 2015.
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To that end, avoiding or even shorting companies with a high degree of earnings manipulation seems sensible. This style was a particular strong performer in Europe and Japan last year. We expect to see similar effects emerging in US stocks this year.
